How California's Public Pension System Broke (And How to Fix

June 2010 Policy Study 382 How California’s Public Pension System Broke (and How to Fix It) by Adam B. Summers Reason Foundation Reason Foundation’s mission is to advance a free society by developing, applying and promoting libertarian prin- ciples, including individual liberty, free markets and the rule of law. We use journalism and public policy research to influence the frameworks and actions of policymakers, journalists and opinion leaders. Reason Foundation’s nonpartisan public policy research promotes choice, competition and a dynamic market economy as the foundation for human dignity and progress. Reason produces rigorous, peer-reviewed research and directly engages the policy process, seeking strategies that emphasize cooperation, flexibility, local knowledge and results. Through practical and innovative approaches to complex problems, Reason seeks to change the way people think about issues and promote policies that allow and encourage individuals and voluntary institutions to flourish. Reason Foundation is a tax-exempt research and education organization as defined under IRS code 501(c)(3). Reason Foundation is supported by voluntary contributions from individuals, foundations and corporations. Copyright © 2010 Reason Foundation. All rights reserved. Reason Foundation How California’s Public Pension System Broke (and How to Fix It) By Adam B. Summers Executive Summary Governments at all levels are struggling to balance their budgets amid falling revenues and rising costs, particularly of government employee pensions. The state of the economy or the stock market is often blamed for poor public pension system health. In reality, pension fund underperformance merely unmasks the volatile—and ultimately unsustainable—nature of the defined-benefit system, particularly at current benefit rates, which are significantly more generous than benefit levels received in the private sector. The defined-benefit structure of the vast majority of government worker retirement plans forces governments (that is, taxpayers) to pay more during recessions to make up for shortfalls in pension fund investments. Not only is the defined-benefit pension system unsustainable, it is unfair to taxpayers in the private sector, who are forced to pay more to recession-proof government workers’ pensions even as they are struggling to save for their own retiree health care costs and seeing their own retirement benefits reduced during rough economic times. Things are markedly different in the private sector. Private sector workers’ pay and benefits are determined primarily by economic realities, rather than by special interest influence. Thus, it is no coincidence that private sector businesses began switching to 401(k)-style defined-contribution retirement plans decades ago, and have by now almost entirely abandoned the defined-benefit plan for being too expensive and too unpredictable. Many of the few businesses that have retained defined-benefit plans, largely those in industries characterized by greater labor union strength, have been forced to dump their pension obligations on the Pension Benefit Guarantee Corporation (PBGC), the quasi-governmental agency created in 1974 to insure private sector pensions. During the last decade alone the PBGC was forced to absorb $1.3 billion in pension claims for National Steel, $1.9 billion for LTV Steel, $3.9 billion for Bethlehem Steel, $3 billion for US Airways, and a whopping $6.6 billion for United Airlines.1 Now the auto industry is facing serious pension problems. Last year, the PBGC assumed responsibility for at least a half-dozen auto supplier pensions covering 100,000 workers and retirees, adding more than $7 billion to the agency’s deficit.2 The Big 3 Detroit automakers themselves are also in trouble, with Chrysler facing a $3.6 billion pension deficit, Ford looking at a $12 billion deficit, and General Motors confronting an $18 billion shortfall.3 There is no such “insurer of last resort” like the PBGC for public sector pension plans, but since vested benefits are guaranteed by the California Constitution, taxpayers are the ones who serve this role and are ultimately on the hook for unfunded pension liabilities. Famous investor Warren Buffett summed up the state of public pension systems in a sobering discussion from the 2007 Shareholder Letter for his Berkshire Hathaway Inc. company: Whatever pension-cost surprises are in store for shareholders down the road, these jolts will be surpassed many times over by those experienced by taxpayers. Public pension promises are huge and, in many cases, funding is woefully inadequate. Because the fuse on this time bomb is long, politicians flinch from inflicting tax pain, given that problems will only become apparent long after these officials have departed. Promises involving very early retirement—sometimes to those in their low 40s—and generous cost-of-living adjustments are easy for these officials to make. In a world where people are living longer and inflation is certain, those promises will be anything but easy to keep.4 While government pension systems across the nation have strained to cope with escalating pension obligations, California is in worse shape than most because of a large increase in pension benefits made a decade ago, raising benefits as much as 50 percent for some state employees and cementing the state’s position as one of the most generous states in the nation in terms of pension and retiree health care benefits. A recent paper by University of Chicago business professor Robert Novy-Marx and Northwestern University finance professor Joshua D. Rauh calculated California’s unfunded liability at about $475 billion.5 Similarly, an April 2010 Stanford Institute for Economic Policy Research study puts the state’s liabilities at around the half-trillion-dollar mark, estimating them at approximately $535 billion.6 That translates to roughly $36,000 for each California household.7 These newer estimates are much higher than prior reported estimates of about $63 billion in unfunded pension liabilities.8 It is often argued that governments must pay greater benefits to their employees because they cannot pay salaries as high as those in the private sector and they need to offer greater benefits and job security to effectively compete with the private sector for quality workers. While perhaps the argument could be made a generation or two ago, it clearly does not hold true today. Now government employees typically make more, on average, in both wages and benefits than their private sector counterparts. According to the U.S. Department of Labor’s Employer Costs for Employee Compensation report for December 2009, state and local government employees earned total compensation of $39.60 an hour, compared to $27.42 an hour for private industry workers—a difference of over 44 percent. This includes 35 percent higher wages and nearly 69 percent greater benefits.9 Data from the U.S. Census Bureau similarly show that in 2007 the average annual salary of a California state government employee was $53,958, nearly 32 percent greater than the average private sector worker ($40,991). Pension Benefit Increases, Benefit Creep and the Growing State Workforce The adoption of SB 400 in 1999 ushered in an era of dramatic pension increases, including the “3 percent at 50” benefit for the California Highway Patrol, whereby a public employee with 30 years of work experience may retire with 90 percent (3 percent for each year of work) of his or her final salary as young as 50 years old, “3 percent at 55” benefit for peace officers and firefighters, and “2 percent at 55” benefit for other state workers. For police, firefighters and other public safety workers, this represented an increase in benefits of between 20 percent and 50 percent. California Standard Pension Benefit Formulas Before and After SB 400 Employee Category Before SB 400 After SB 400 (Effective January 1, 2000) Miscellaneous/Industrial 2% at 60 2% at 55 Safety 2% at 55 2.5% at 55 Peace Officer/Firefighter 2.5% at 55 3% at 55 Highway Patrol 2% at 50 3% at 50 Source: California Legislative Analyst’s Office, “State Employee Compensation: The Recently Approved Package,” December 6, 1999, http://www.lao.ca.gov/1999/120699_employee_comp.html. Moreover, the benefit increases were retroactive, meaning that the aforementioned pension increases of up to 50 percent were, as former Sacramento Bee columnist Daniel Weintraub observed, “not only for future employees but for workers whose retirement contributions had been based for decades on the expectation of a lower benefit.”10 These added benefits now cost the state hundreds of millions of dollars per year. The state will be paying for those benefit increases for decades to come. As a result of these benefit levels, there are 9,111 state and local government retirees in California, such as police officers, firefighters and prison guards, who receive pensions of at least $100,000 a year (through CalPERS), and an additional 3,065 retired teachers and school administrators who receive pensions over $100,000 a year (through CalSTRS).11 But the government need not change pension benefit rates to increase benefits. For decades, “benefit creep” has allowed more government employees to move up into higher benefit plans. This is particularly true for “public safety” employees in California. As a Sacramento Bee article relates, Prison cooks, plumbers, groundskeepers, teachers, dentists, business managers, and “audiovisual specialists”—all are among the 70,000 state workers considered police or firefighters, eligible to retire with better benefits than other state workers. In fact, any worker in a California prison regularly in contact with inmates is considered a police officer, rewarded with a richer public pension for helping safeguard society. The same goes for workers in state mental hospitals—from psychiatrists to podiatrists—who supervise patients.12 In the 1960s, roughly one in 20 state employees received public safety pensions. Now it is one in three workers.13 Another problem is the sheer number of workers that the state employs (at great cost).

Load more